Threats to stability

RBI flags major risks to India's banking system

The Financial Stability Report of the Reserve Bank of India, published earlier this week, comes at a particularly important juncture in terms of the somewhat contradictory signals that are emanating from the economy. As the report itself highlights, on the macroeconomic front, things are more comfortable than they have been for a while. While on the global front, there are still some signs of stress, in the form of sluggish growth in Europe, Japan and several large emerging economies, conditions have generally turned favourable for India, particularly with the sharp decline in energy prices. Capital inflows are likely to remain steady in response to India's relatively strong position in the emerging markets portfolio. Lower oil prices have generated a triple dividend for India with declining inflation, a narrower current account deficit and a smaller subsidy bill.

But that's as far as the good news goes. The rest of the report paints a rather grim picture about the overall state of the financial sector. It points out that the banking system has steadily been losing momentum in terms of both deposit mobilisation and credit provision. The low growth rate of credit, in particular, is a source of concern in relation to the signs of recovery that the economy has been showing of late. Even as the report points out that other sources of finance have begun to supplant bank credit, the latter remains a core source of finance for everyday production and trade activities and its unavailability could threaten the nascent revival. However, the biggest threat to financial stability in the report's assessment is the huge build-up in non-performing assets in the banking system, with the public sector banks as a group being the worst affected. Once again, this seriously compromises the ability of this group of banks to provide credit; it also sucks out a large share of the already dwindling profit base as provisions. At a time when these banks need large enhancements of capital to comply with Basel-III norms, this combination of factors poses a huge challenge to the banks and their owner, the government. As if the problems with individual banks were not enough, analysis of linkages between large banks highlights threats from contagion in the event of stress in any one of the five largest banks.

Having red-flagged the banking system in general, the report focuses on some specific problems. Of late, there has been a vigorous public debate on defaults on loans and the rather lenient treatment that defaulters receive. This issue is highlighted in the report from the perspective of "double leveraging" or the act of borrowing by promoters to invest in the equity of their operating businesses. The report points out that this can quickly cascade into unsustainably high leverage, which increases the likelihood of default. On a large scale, defaults inevitably become a political problem. The report ends with an effort to provide some reassurances, based on steps that regulators are taking to contain and mitigate the various risks building up in the system. But notwithstanding these, the overall message of the report is sobering. The larger consequences of a fragile financial system were amply demonstrated during the financial crisis of 2008. India cannot afford a repeat performance in its own backyard.